Mastering Derivatives: Know these rules to capture time decay

Venkatesh Bangaruswamy | Updated on: Jul 23, 2022

Time value of an option consists of time to maturity and implied volatility

Empirical evidence suggests that most options expire worthless. Small wonder that we received a query on how to capture time decay trading options. This week, we discuss the rules you must apply to profit from time decay.

Time decay capture

Time decay refers to the loss in time value of an option with each passing day to its eventual value of zero at expiry. You should short options that will most likely expire worthless to capture time decay.

We know that time value of an option consists of time to maturity and implied volatility. When you are comparing options of the same expiry to set up your short position, the difference in time decay between these options is because of the option’s implied volatility.

Note that implied volatility is also a function of the demand for a strike. Higher the demand, higher the option price. Higher the price, higher the time value, and higher the implied volatility, all else being the same. Logically then, when implied volatility declines, time decay accelerates. This now sets the stage to frame rules to capture time decay.

Key rules

First, you should have a view that the underlying is likely to move sideways. When the underlying moves sideways, implied volatility reduces, accelerating time decay.

Second, compare put volatility and call volatility. Since gains from time decay is also dependent on volatility declining, you must select the option that has higher implied volatility; for this is the option likely to have accelerated time decay when implied volatility declines (implodes).

Third, if the implied volatility between puts and calls are similar, then check if you have a marginal bias about your view on the underlying. That is, do you expect a marginal upside or downside in the underlying price movement? If you expect the underlying to move up marginally, then consider shorting a put. If you expect the underlying to marginally move down, then shorting a call would be optimal.

Fourth, if you are fearful that the underlying would move adversely against your short put or short call position and gather large losses, consider setting up a spread.

The simplest spreads are bull put spread and bear call spread. Bull put spread involves shorting a higher strike put and buying a lower strike put. The bear call spread involves shorting a lower strike call and buying a higher strike call.

The long strike should be based on price level at which the underlying is likely to gather momentum.

For instance, if you expect the underlying to breakout above 270, then you should buy the 270 call when setting up a bear call spread. Your losses will be limited to the difference between the two strikes less the net credit (net premium collected to setup the spread).

Optional reading

Your choice of strikes for the short position should be between immediate in-the-money (ITM), at-the-money (ATM) and two immediate out-of-the-money (OTM) strikes. The advantage of shorting an immediate ITM strike is that the loss in option value will be high if you are applying rule three discussed above.

Suppose you short an ITM call because you expect the underlying to decline. This call will lose value because of time decay and delta. As delta is a large number, the short ITM option will gain more than same-maturity ATM or OTM option, whose gains are primarily from time decay. If implied volatility implodes, vega will add to the gains. Only the option’s gamma will work against the short position. Being a small number, the gamma can only slow the speed of the delta.

If you already hold a stock, applying rules one and four, you can capture time decay by shorting a near-month at-the-money (ATM) option on the stock. Traders also setup time spreads and switch trades to capture time decay. We will leave that discussion for a later date.

(The author offers training programmes for individuals to manage their personal investments)

Published on July 21, 2022
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